Ammunition for the regulation industry

The December BIS Quarterly review contains an interesting piece which analyses the performance since 2007 of the three main classes of banks – retail funded, wholesale funded and trading led.

Its broad conclusions are:

There has been a marked shift away from wholesale funding to retail funding, while the number of trading-led banks has remained constant.

Profitability of all three models has fallen sharply, but trading-led banks have suffered the most.

Trading-led banks have gone from the most profitable sector, with ROE approaching 20%, in 2007, to the least, with ROE of 5%, in 2013.

Trading-led banks have consistently had the highest cost-income ratios, at approximately 70% versus 60% for retail banks and 50% for those which fund mainly in the wholesale markets.

Trading-led banks carry significantly more capital, with a capital adequacy ratio of 17.3% versus 14.6% for retail banks and 12.2% for wholesale.

So, trading-led banks demand more capital, have significantly higher costs in relation to income, have suffered the most severe fall in profitability, are the least profitable and worst performing of the three groups. However, their numbers have not shrunk to reflect these factors, whereas the number of wholesale-funded banks – which have not performed as badly – has shrunk substantially.

The authors of the report surmise that the reason for this is that investment bankers pay themselves so well that they are loath to change their business model – they organise their banks for themselves, in other words, rather than their clients or shareholders. This may or may not be true – after all, past busts have been followed by booms, and banks which closed down or cut too deeply missed out – but the BIS’s view is undoubtedly the one that will gain traction.

This will inevitably provide more ammunition for the UK’s politicians and regulators to squeeze the investment banks. Already, they have taken powers for themselves to control what and how bankers are paid, and are imposing limitations on risk that will make it harder than ever for investment banks to produce worthwhile levels of profitability even if and when the good times return.

All this means that it is more vital than ever before that banks understand and control their risks (and risk takers), that costs are kept under control and that management is kept fully aware of any business or reputational threat before it blows up into yet another scandal. All in all, therefore, the role of internal audit has never been more important.